Finding The Next Great Stock To Cover

Ryan Modesto How do you decide which companies to cover? This is a question we get often from our members at 5i Research. Of the hundreds of companies out there, we have worked our list down to roughly 70 stocks that we feel warrant attention for one reason or another. Deciding which 70 stocks this should be is the tough part, and we find that there are three “buckets” within which we find stocks that are worth covering. Not each bucket is as big as the other, but the following areas are typically the common factors that get us interested in a stock and end up being a company we view as worth an investor’s time and money. The three areas are: Special Situations, Businesses of the “Future” and “Fundamental Growth”.

There are a lot of “good” companies out there with good fundamentals such as high margins and strong balance sheets. Great companies are harder to find though, and while we can find the numerous companies out there that make the “good list” with relative ease (through tools like Bloomberg), there needs to be something extra that takes a good company to a great investment. The three areas we are outlining are the ones that make us more confident that if a good company falls into one of these categories, it has a chance to also be a great company for an investor to own. Of course, even if a stock falls into these three categories, there needs to be some sort of minimum test the company passes before it warrants a look.

While not a comprehensive list, here are some of the things we first want to see at a company before we dive into the research process:

Growing revenues: No growth points to issues or a mature business.
Low analyst coverage: Less eyes on the stocks mean less efficiencies in the market. Plenty of great Canadian companies are publicly traded but get no attention simply because they are unlikely to bring the banks business through deals and financings.
Market-capitalization greater than $100 million: Building a business is hard. Building a $100 million business is very hard but acts as a natural filter for quality companies that can rise to this level while keeping more speculative companies out.
Strong balance sheet: Can be measured in various ways, but there needs to be flexibility to weather the hard times.
Insider ownership: High levels of ownership or increased buying of shares by executives.
Low/no share dilution: Issuing shares is a cost to current/loyal shareholders.
Shareholder friendly: Dividends, increasing dividends, share buybacks.
Good return on equity: Shows a company is generating returns on YOUR money.
Momentum/new highs: Companies hit new highs for a reason, usually something good is happening that is worth paying attention to.
Strong/Incentivized management teams: Good track records, history, and appropriate incentives that align interests with shareholders can go a long way.

Again, this is not a comprehensive list and not every aspect needs to be fulfilled to warrant interest, but some of these factors should be present in a 5i Research coverage company to make us consider a company in the first place. Of course, many companies may exhibit some or many of these above attributes. With our coverage list of what we hope to be some of the best companies in Canada, we still need to be even more selective. This is where the ‘buckets’ come in for us. With these metrics present and if a company falls into the three categories below, in our view it is this combination that can take the good companies (fitting into the mould above) and make them great companies.

Special Situations

This is the area we look at the least, often because it can be one of the more speculative areas, or risks can be elevated at the time of the “situation” in question. Typically, a special situation arises when some sort of unique event occurs, and it creates some sort of mispricing in a stock. It could be an exaggerated reaction due to fears or a strategic move such as an acquisition that is not being understood. Two great examples of a special situation that catches our eye would be Photon Control and Transcontinental.

Photon Control had gone through some unusual headlines in 2017 when money went missing from the company bank account and the company ended up in litigation with the R&D subsidiary and it looked like it could have been a company ending event. Eventually, everything was settled in favour of Photon but markets (rightly so), were still slow to warm up to the name again. This situation created an opportunity in a name that was seeing growth and had the legal issues put behind it and more nimble investors were able to act quickly on the shares while the market took time to catch up to the story. Big company events like this often create some opportunity in the shares. Fortunately, since we added coverage of the name back in May 2017 at $1.35, the company has returned 67% and prospects look better than ever.

Transcontinental is a company recently added to one of our model portfolios and has undergone a large acquisition of a packaging company, helping them transition away from the slower growth printing business. Meanwhile, the valuation is still largely reflecting that of a printing company (cheap) vs. that of a packaging company that typically trades at a premium. The verdict is still out on this company but is another good example of a special situation that arises where our interest is piqued.

Businesses of the Future

These are companies which are growing fast, have a large addressable market and are essentially building out a new market on their own or are the first in a group to build out a market. They are unique in the sense that most, if any, cannot foresee where these companies will be in five to ten years. Of course, these usually come with high valuations but often what look like a high valuation today can be cheap five years from now. Typically, these include companies that operate in cutting-edge sectors like gene editing or artificial intelligence but can also just be companies that are growing at blistering speeds. If a company has quality fundamentals (like cash on the balance sheet and growing revenues), is growing faster than everyone else because they are doing something different or have found a better way and/or is in a new field of technology, it catches our eye.

Similar to the Special Situations, these make up a smaller portion of our overall ideas and coverage names simply because they are higher risk and can be volatile. The FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks are the easiest examples here but within Canada, companies like Kinaxis and Shopify fit the bill in our view as well. The important point here is that in very few instances, if at all, should a portfolio be dominated by names like this. We do believe though, that if an investor wants those big winners in a portfolio, they need to dabble a little in these areas and try to own some of those businesses of the future. Any portfolio that has not owned the FAANG stocks, or technology in general, has likely forgone some unprecedented returns over the last few years. Not all will work out but often if only one works out well, it will cover the costs and then some of the poor performers. Adding in some quality filters like we mentioned earlier, and this can go a long way to separating the speculative names from the ones with a real business showing potential. The important consideration here is to invest, think long-term, and not gamble for a quick win on names like these.

Fundamental Growth

This area is where we find the majority of 5i Research companies. These are the companies that have strong fundamentals and are simply doing something better than their peers, or everyone for that matter, which is borne out in the trend of the fundamentals. The longer-term trend of operations becomes important here. For a company to fall into this bucket, they cannot have a single good quarter, they have had to post a string of good quarters or years where the fundamentals continue to show improvement. This would include things like growing revenues, growing margins, continued insider buying or share buybacks, or declining leverage to name a few. The key here is not just the growth, but the consistency in the growth. Metrics like this typically indicate that the company is on to something and is doing something better than their competition or doing something different that others have yet to catch on to.

Unfortunately, these companies can be some of the tougher ones to find as they are not “in your face” like a takeover or a flashy tech stock (these companies can also be boring names). It can take markets time to catch on to the improving fundamentals and to start to believe the improvements are sustainable versus a flash in the pan. So, this is where the digging needs to come in to discover what that “thing” is and why it is working well for the specific company. Of course, the factor that is leading to one company’s success can vary from scenario to scenario. So, these can be some of the harder investments to uncover but also offer less volatility and risk compared to the above items mentioned. Fortunately, while these can take time to find, this is exactly what we spend our time on at 5i Research.

We have three great examples of companies that fit into this bucket: A&W Income Fund (AW.UN), BRP Inc. (DOO) and Savaria (SIS).

A&W is the burger chain best known for their root beer. The stock AW.UN is a royalty income fund that takes a royalty on revenues of the A&W franchises and pays the royalties out in the form of a distribution to the shareholders. These restaurant royalty names tend to be slow growth and more boring names but something was leading to high same-store sales growth at A&W that other companies were not seeing. Digging into management commentary, they were pointing to two things: a marketing campaign focused on better ingredients as well as franchises that had a smaller footprint and allowed them to grow in urban areas. For whatever reason, markets were not believing the same-store sales growth numbers the company was posting, in the 3% to 6% range compared to peers that were largely flat. The high same-store growth number supported by management initiatives is a great example of a nugget that is hard to find without a bit of digging. Fortunately, AW.UN has returned 67% since we began coverage in February 2012, not including the distribution which has yielded 4% to 6% over the years.

BRP Inc. is the maker of Sea Doos and Ski Doos as well as ATVs. What made this name first jump on our radar was when it initiated its first dividend, which we view as a very strong signal to investors about the expected future of the company. Looking further into the name, it was apparent they were seeing plenty of opportunity through markets in China as well as through improved digital marketing practices. Finally, the company has a bit of an unusual balance sheet due to its history with Bombardier making it less likely to ‘screen’ well for investors but was actually in pretty good shape. This was another case of a company that had strong and growing fundamentals as well as a large market they have just started entering. Since we started coverage of DOO back in July 2017, and added it to one of our model portfolios, the company has returned 85%.

Savaria, a seller of elevator lifts, adaptive vehicles and mobility products, is our final example and one of our favourite companies. It ticks almost all the boxes at 5i Research with a strong management team that has a large ownership stake, growing revenues, strong balance sheet, unique niche in a growing market (it serves boomers), low analyst coverage (initially), and shareholder friendly. So, the fundamentals lined up great but more importantly, they were growing quickly and it was getting no credit for this growth. Finally, after a few quarters and acquisitions, a company that was trading at 16 times earnings with strong growth in the fundamentals saw its valuation expand to 23 times forward earnings and has returned 184% (before dividends) since we began coverage back in February 2016. Savaria is another great example of a company that had not just good fundamentals but consistently growing fundamentals as well as clear plans to increase their market share over time.

Hindsight is always 20/20 and not every company we cover works out as well as we had hoped, and some are not intended to be high growth. Having a way to sort through the numerous opportunities out there and finding ways to focus in on quality companies that have high potential can go a long way towards tilting the odds in your favour. This is what we aim to do; be a part of the research process that helps investors find good companies they may have never heard about otherwise. So far, we are happy with the way our coverage “universe” has fared and are excited to continue to try to uncover the next great Canadian companies over the years.

Ryan Modesto, CFA, is Chief Executive Officer at 5i Research Inc. in Waterloo, Ontario. He can be reached at ryanmodesto@5iresearch.ca